Schmitt Industries (NASDAQ:SMIT) is a company that designs, manufactures and sells niche precision test and measurement products for industrial use. The company's only production facility is in Portland, Oregon and operates within two main segments. Through the balancer segment, it focuses on its product offering of Schmitt Dynamics Balance System (SBS) mainly for grinding machines. This segment was accounting for 60% of the sales for FY2016 (the company ends yearly accounting on the 31st of May each year). Through the measurement segment, the company is focused on product offering of various laser-based devices that measure distances and areas. This segment accounted for 40% of the sales for FY2016. The total revenue run rate for FY2016 came in at $11.68 million with the gross margin of 41.6% and a negative operating margin of 12.2%.
The company is offering these products internationally and the following areas accounted for the past sales.
I believe that investors might be attracted to SMIT due to its valuation. The stock is currently trading below its NCAV value and the most recent share price downturn made the price-to-tangible book ratio seem attractive as well.
But one might say that the current valuation is offset by the negative fundamentals of the business, which are the following:
- The management fails to meaningfully increase the revenue streams. The latest product that was touted as a potential growth driver was brought to the market roughly six years ago and has failed to bring more business. The commodity nature of the business also prevents differentiation and new revenue opportunities.
- The company is unable to shrink its operational cost base and the gross margins most likely rely on the product mix, which the management does not seem to be able to influence. This prevents the company to generate any meaningful cash flow and create shareholder value.
- The management is likely complacent about the whole situation as the board did not change radically for an extended period of time.
That being said, as the company is unable to meaningfully change the fundamentals the management might be incentivized to rethink on how to continue. I would not be surprised if the company decided to either go for a strategic review, with a sale being the most likely scenario or take the company private. The presence of Buttonwood Tree Value fund, activist investors, might support this scenario.
While the company seems to be confident that its products are unique and provide solid value to the customer, I believe that this is unlikely to be the case and that most of the product offering is commodity-like. As an example, we can look at what the management claims about its Xact Tank Monitoring System, which the management touted as a growth driver in 2011;
Management believes that the Xact Tank Monitoring System offers the only ultrasonic sensor specifically designed to provide independent precise tank level calculation while most other competitors utilize gauge-reading technology, which reads the tank fill level from a pre-installed float gauge and is less accurate. Competitors offer telemetry options based on cellular or closed loop communication networks whereas Xact telemetry is satellite-based.
Source: 10-K for FY2016
I believe that the claim does seem to hold, but the context shows that the advantage seems to be most likely negligible.
First, the fact that Xact uses an ultrasonic sensor is nothing groundbreaking. There are several competitors providing this solution as can be seen in this comparison report. Second, the satellite-based system is also not unusual. NASCorp, for example, uses the same system. Furthermore, there are companies that specialize in providing the satellite-based system to any kind of fuel tank monitoring system (including ultrasonic sensors), like for example Bentek Systems.
This means that Xact might provide a 'new solution' as it combines these two factors, but as it has been on the market since at least the year 2009 and failed to enable the company to gain much revenue, it is unlikely to have a meaningful advantage. I would say that this is likely to be true for the rest of the company's offering as well.
Therefore, the fundamental operations are mainly about operational efficiency, which SMIT does not seem to be able to achieve. Firstly, the management does not seem to be able to hold the gross margin stable as it recently started to decline.
The company blames 'product mix' for these recent developments (taken from comments on 10-Qs). This means that it is unlikely to do much about it as it is unable to sell higher-margin products. On its own, this would not be such an issue if it were to be capable of improving its operational cost base. This though is not the case as seen below.
The company is unable to stabilize the margins and in 2015 the company had the worst year since the financial crisis. Also, the company has been able to turn a profit only sporadically and when it happened, it was not meaningful. What is more disconcerting is that the company does not seem to even actively try to reduce the operational cost as the commentary on SG&A expense mainly talks about travel, personal expense and entertainment as the main drivers behind the changes QoQ and YoY. An example of which can be seen below.
Operating expenses decreased $133,278, or 8.2%, to $1,491,516 for the three months ended August 31, 2016, as compared to $1,624,794 for the three months ended August 31, 2015. General, administrative and selling expenses decreased $125,213, or 8.1%, for the three months ended August 31, 2016, as compared to the same period in the prior year primarily due to a reduction in travel and entertainment expense and decreases in personnel expenses.
Source: 10-Q for Q1 of FY2017
If this is indeed the case it could still mean that the business operations could be improved upon (as SMIT might not have tried to cut the other expenses), but if the only thing that the management can change is personal expenses than the business could be in slow but stable decline.
Finally, the fact that the business is unable to meaningfully break even then means that the company's cash flow is almost non-existent and the company is just slowly burning its cash position and is unable to produce any shareholder value.
As mentioned, the management has not done much about the operational issues for a prolonged period of time. I believe that part of the reason might be the fact that the board did not significantly change over time. The current chairman, Mr. Wayne A. Case, has been on SMIT's board since 1992 and while the CEO Mr. Fitzhenry was recently replaced, the substitute, Mr. David Hudson was already a board of member of SMIT and therefore, it does not seem that much should change. Furthermore, Mr. Case's son, David Case is currently the vice president of the company, which again points to a likely continuation of the status quo.
What I believe could though spur some change is the fact that the aforementioned board members do not own a significant stake in the company, at least in comparison with similar micro-caps companies with stable management. Altogether they own roughly 14.8% which might not be enough to 'protect' the status quo should an activist try to shake things up.
Furthermore, as there are three major outside shareholders this is not a far-fetched scenario. While Mr. Brown Pistor, an individual investor, who owns 17% or Monongahela Capital Management, which owns 14.1% are not known for any previous activist campaigns, Buttonwood Tree Value partners are. They even went beyond classic activist campaigning and pursued lawsuits against several boards and managements, like for example against R.L. Polk & Co., management of which supposedly knowingly undervalued the company during a tender offer.
They though own only 5.5% of SMIT, which might limit their efforts should the others go against the campaign. It is also unclear whether the position in SMIT (valued at $0.3 million) is big enough for them to focus on the potential campaign.
One has to point out that shareholders do seem to start to manifest their discontent as an unusual number of votes have been cast in rejection of the most recent vote regarding the election of two directors, which did not use to happen. It is though only a speculation if any of the major shareholders were behind this.
Should the scenario play out, the activist could probably push for a sale of the business as there are competitors that might benefit from parts of SMIT's business and as the company does not seem to be able to bring in a meaningful amount of cash flow.
While the business and the management are likely stuck in a stale status quo, the valuation is likely offering partial downside protection should the situation continue for the long term. As mentioned, the company is currently trading below its NCAV value as seen below.
The NCAV value consists mainly of inventories as seen below.
The inventories should be fairly liquid as $2 million of the total amount is in raw materials.
Moreover, while the Days of Inventory Outstanding (DIO) is high, it is not deteriorating, which could again mean that the inventory valuation is not likely to be overvalued significantly.
This then constitutes a reasonable margin of safety and should investors believe that a shake-up of operations occurs then they might be able to have enough downside protection.
I believe that there are not many ways for shareholders to see value from this investment. The most likely scenario is that either the management or the large shareholders push the company to either go through a strategic review, with a sale being the most attractive option given current valuation, or go private which could enable the company to slash part of its costs.
This is a reasonable assumption due to the fact that the company fails to improve the fundamental outlook in all three main efforts. It fails to increase volume, it is unable to lessen the operational cost and the gross margins seem to rely on the product mix, which the management does not seem to be able to influence.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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